Relationship between IFRS Adoption and Financial Report Readability for Australian Companies

2674 words (11 pages) Essay in Accounting

08/02/20 Accounting Reference this

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1 Executive summary

The impact and relationship between the international financial reporting standards (IFRS) adoption of the Australian companies’ financial reports’ readability will be mainly discussed in this report. Firstly, according to the research result of Cheung and Lau (2016), the text length of financial reports has increased and the complexity has decreased in the post-IFRS adoption period, so the readability of financial reports has improved. Secondly, the length of the notes disclosed has increased significantly in the specific accounting policies. So it will require more disclosure of these selected accounting principles after IFRS adoption. Moreover, IFRS adoption has both advantages and disadvantages. Although Australia adopts IFRS, the accounting procedures and practices that these companies used are not necessarily can be internationally consistent and comparable.

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2 Introduction

Most countries now adopt IFRS, and the purpose of IFRS is to set a better accounting standard to provide clearer disclosure. (Aasb.gov.au, 2004). Australia began adopting International Financial Reporting Standards in 2005. The report mainly analyses the relationship between adopting IFRS and the Australian companies’ financial report’s readability based on the results of Cheung and Lau’s research report. Firstly, analyse the importance and measurement of readability, where measurement readability consists of two dimensions: length and complexity. Secondly, discuss the impact of adopting IFRS on readability and selected accounting policies. Moreover, discuss the advantages and disadvantages of adopting IFRS.

3 Analyse readability

3.1 Why readability is important?

In relation to the importance of readability, Firstly, communicate effectively with the target users is important. Because the main purpose of communication is to transfer the information that the sender wants to others, so the information must be delivered in a reliable and understandable way. If the information cannot be properly understood by the target user, then this will be less useful for the user’s decision making and monitoring purposes (Cheung and Lau, 2016). The effectiveness of communication not only depends on the user’s ability to understand but also depends on whether the sender’s information has better readability. All public companies publish annual financial reports because this is the way information is communicated between business managers and shareholders. Management can effectively disseminate information and make decisions through financial reports, and investors can make predictions about future returns based on the annual reports (Baker and Kare, 1992). But not all users have the accounting background, so the most important feature of financial report is to be easy-to-understand because it can effectively help users make the right decisions. Secondly, the effectiveness of financial report can be affected by readability and comprehensibility. The readability of financial reports is determined by the writer, and comprehensibility is determined by the user. The important feature of financial report is the need to present financial information so that users can easily understand it. So the financial report should be more readable to ensure that all users understand the content of the financial report. And the information in the financial reports must be reliable and effectively contain the company’s financial performance. Therefore, high-quality financial reports should disclose the company’s financial information in detail and better to make it more readable for users. Moreover, Li (2008) states that many research results show that the financial reports’ readability will influence the current income and future sustainable income. The trading behavior of investor, analyst’s following and analysts’ reports are all affected by the readability of financial reports (Cheung and Lau, 2016). Li (2008) states that the companies with easy-to-read financial reports can obtain longer-lasting profitable income, while financial reports with lower-income companies are hard to understand and read. According to Miller (2010), because the readability of financial reports allows investors to better understand the company’s scale, financial position and financial performance, so it will effect the trading activities of investors. According to De Franco et al. (2013), the higher readability reports will provide more understandable analyst report and the quantity of trading will increase.

3.2 Readability measurement

Cheung and Lau (2016) state that measuring the financial report’s readability through two dimensions which are length and complexity. The length is measured by the number of words reported, and normally longer reports are less readable. However, the research results show that more text reports can disclose more detailed information and after the adoption of IFRS improved readability. The fog index is used to measure the complexity and it is a function that represents the length of a sentence and the percentage of complex words that includes three or more syllables. Normally higher fog index has less readability and vice versa.

4 The relationship between adopting IFRS and the Australian companies’ financial report’s readability

4.1 Influence on readability

According to Cheung and Lau (2016), they measure the readability of financial report by words length and complexity, and in order to analyse the relationship between adopting IFRS and the Australian companies’ financial report’s readability, they selected samples from all Australian companies listed on the ASX. Firstly, according to Ding et al (2007), compare with most domestic accounting standards, IFRS need greater disclosures. This may be because the number of words will increase after the IFRS adoption. According to Figure 1, Cheung and Lau analysed the selected data and found that after IFRS adoption the length of words has increased. For example, average number of words increased from 14961 to 23949, and the median increased from 13328 to 25058. The mean of length increased from 9.47 to 9.97, and the median increased from 9.5 to 10.13, but the fog index has declined.

Secondly, Cheung and Lau (2016) state that partners in KPMG and Ernst & Young, and other investors in the capital markets, companies and participants agree that after IFRS adoption will lead to increases in length of financial report. Because of the benefits and drawbacks of adopting IFRS, people worry that adopting IFRS will result in financial reports that are too long to read and hard to understand. However, longer financial reports will disclose a wider range of information, which can help users to understand the company in more detail and make the better decision. Furthermore, another important element of readability is complexity, and there is much controversy about the degree of complexity of financial report after adopting IFRS. According to Hoogendoorn (2006), IFRS is not only too complicated for professional auditors and other experts, but also financial report is difficult to read and understand for most users after adopting IFRS. In addition, Haswell and Langfield-Smith (2008) states that there are many deficiencies in the IFRS of Australia, so its probably not be possible to improve the quality of disclosure of financial reports. However, according to Cheung and Lau’s findings, after using IFRS, the average value of the fog index dropped from 17.87 to 17.47, and the median dropped from 18.17 to 17.47(shown in Figure 1). The readability of financial reports has improved with the IFRS adoption, because of relative decreases in fog index. The main reason is that IFRS is written in simple English, so it can help users reduce confusion and make it easier to understand. And IFRS can be intuitively understood, easy to explain and easy to present facts (Cheung and Lau,2016). Based on the above analysis, the words length becomes longer but contained simple words after adopting IFRS. Therefore, the IFRS adoption will lead to increase the length of financial reports and reduce the complexity. And it helps to reduce the user’s confusion about financial report and increase the transparency, which means that the readability of financial reports will improve. Actually, Australia’s financial reports still have problems that are difficult to understand and read, although the readability has improved with the adoption of IFRS.

Figure 1

                                                       (Cheung and Lau, 2016)

4.2 Influence on accounting standards & policies

Cheung and Lau (2016) hypothesized that the text length of some accounting policies will be affected by adopting IFRS. Accounting policies such as financial instruments, share-based payments and intangible assets are affected. According to figure 2, compared with the prior adoption of IFRS. Due to adopting IFRS, the length of all specific accounting policies has increased. The average number of summary words increased from 2324 to 5201, while the median increased from 2128 to 4994. And after adopting IFRS, the average number of words for financial instruments and share-based payment increased by 2-3 times, and the median number of words of intangible assets also rose from 0 to 209.However, in terms of intangible assets, the average disclosure number of intangible assets before adopting IFRS is zero. This indicates that intangible assets were not disclosed in the financial report before the adoption of IFRS. Cheung and Lau (2016) state that the situation began to change due to restrictions on transparency after adopting IFRS. And through regression model analysis, it is proved that their hypothesis is correct. The length of a particular accounting policy does increase significantly after IFRS adoption. Therefore, this indicates that with the adoption of IFRS, Australian companies need to disclose more details of these selected accounting policies in their financial report.

Figure 2

                                                      (Cheung and Lau, 2016)

5 Critical discussion 

Based on the above analysis, there are two important findings regarding the relationship between adopting IFRS and Australian companies’ financial reports’ readability. Firstly, after Australia adopting IFRS, the financial report becomes more readable, as the length of the text has increased and complexity has decreased. Compared with before the IFRS adoption, the length of the text in the post-IFRS period has increased, but it contains simple words. This will not only reduce the confusion and misunderstanding of users but also increase the transparency of financial reports. Secondly, the length of a particular accounting policy has increased significantly after the IFRS adoption. Because of Australia adopts IFRS, so Australian companies need to disclose more in their financial report for these specific accounting policies.

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In general, adopting IFRS has both benefits and drawbacks. Adopting IFRS can increase transparency, comprehensibility and reduce the complexity of information. As a result, financial reporting becomes more readable. In terms of the disadvantages of Australian companies adopting IFRS, the company’s overall cost will increase and the conversion to IFRS will cost time (Afaque, 2014). And due to differences in culture, economic influences and legal systems, financial accounting practices may be affected (Deegan, 2014). Australia companies prepared the financial report according to Australian generally accepted accounting principle in pre-IFRS adoption period. Therefore, IFRS for Australian companies is a completely new system that is unfamiliar and it may not be easier to implement, although the readability of financial reports after using IFRS has improved. According to Yip and Young (2012), the adoption of IFRS can improve the comparability of information, due to IFRS adoption helps to make similar things look more similar. Due to all companies follow the same accounting standards, so different companies can use information in the same way. However, this does not necessarily mean that all companies use the same accounting procedures and practices, and the comparability will be affected by the different institutional environment of different companies.

6 Conclusion

Overall, based on Cheung and Lau’s research, this report discussed the relationship between adopting IFRS and the Australian companies’ financial report’s readability. Firstly, according to the research results, adopting IFRS will lead to an increase in the length of the text and reduce the complexity of the report, so the readability of financial report has improved. And the reduction in complexity after adopting IFRS is due to the fact that the report is written in simple words, thus improving the transparency of the financial report and reducing confusion and misunderstandings of users. Secondly, after adopting IFRS, the length of the four accounting policies has increased significantly, which means that the IFRS adoption will require more disclosure of these specific accounting policies. Furthermore, IFRS adoption has both benefits and drawbacks. For example, benefits include increased transparency, comprehensibility, and reduced information complexity, thus the financial report becomes more readable. The drawback is that adopting IFRS will cost a lot of time and money, and so on. Moreover, this report has limitations at the same time because the readability formula is based on the simple hypothesis, and it is used to measure the average length of words and sentences. Therefore, it ignores other important factors that may influence on financial report’s readability.

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